Access to financial markets has become available to the broader public in recent years. Thanks to online trading platforms, everyone can now invest from their computer using a trading platform. While some words such as “leverage” or “stop-loss” are no longer a secret for many, it is still obscure financial jargon for others. This article demystifies trading with leverage and gives some insight into why to trade with leverage.
What is Trading with Leverage?
So, let’s see what trading with leverage really is. In financial markets, leverage is used to increase exposure to changes (upward or downward) in an underlying asset, for example, a stock. Leverage means using money borrowed from a broker to open a position.
Sometimes traders want to apply leverage to gain higher exposure with minimal equity as part of their investment strategy. Leverage can be used to buy (long) and sell (short) positions. It is important to note that the losses could be multiplied, as can the profits.
Leverage is, therefore, generally an intrinsic element of a derivative such as a Contract For Difference (CFD). Currently, most trading intermediaries favour the use of CFDs for investing in the financial markets. For example, instead of buying a Netflix stock, a trader buys a CFD linked to the Netflix stock price.
CFDs are complex instruments generally associated with leverage. Here is an example of how you can profit from trading CFDs with leverage. If the trader decides to buy a CFD on the upside with leverage of 5 (5: 1), and the Netflix share price increases by 5%, the trader will have gained five times as much, or 25% over to its initial investment.
Conversely, if the stock price drops 5%, the trader will also lose five times as much. We must, therefore, be aware of the associated risk. Trading with leverage allows you to maximize the potential of your capital which is its main advantage.
Investing With or Without Leverage
Now that we have answered the question of what leverage is let’s check the differences between investing with and without leverage. The first is exposure to the risk of losing money which increases with the use of leverage.
Leverage also has an associated cost. In particular, it is necessary to consider the commissions, spreads or even the costs incurred when maintaining an “overnight” position, that is to say, after the market has closed.
These fees vary from one intermediary to another. Despite these costs, the leverage effect is particularly interesting for taking advantage of market fluctuations, particularly in liquid and dynamic financial markets such as forex or for investments in the technology sector.
Short-term investors will be more inclined to use leverage in the hopes of making quick wins. Finally, the two forms of investing also denote a different mindset.
Investing with leverage brings an additional level of stress that cautious investors will not always appreciate. The speed of reaction when trading with leverage should also be higher in the event of market fluctuations to limit losses.
The Leverage Effect Used on a Daily Basis
Does borrowing to increase your investment potential remind you of anything? It’s quite natural. Leverage is the basis of many investments. In many businesses, it is a well-known financing method.
Some would say that leverage is a double-edged sword. Losing money rapidly is just one of the possible scenarios. However, used wisely, it is a fantastic trading tool, allowing individuals with less capital to access markets that were once out of reach.
Which Instruments Allow Trading with Leverage
Leverage can be suitable in trading stocks, currencies, ETFs, commodities and indices, and in some cases, cryptocurrencies.
Each instrument has maximum leverage limits, which are dictated by industry regulations and the broker’s own efforts to encourage responsible trading and reduce the risks of trading with high leverage.
The maximum exposure will also vary depending on the type of trading accounts. Usually, a business client account allows for higher leverage and offers other benefits such as reduced margin requirements and zero withdrawal fees. Only clients who meet specific criteria can apply to become professional clients.
How to Reduce the Risk of Trading with Leverage
To help you reduce the potential risk, there are many risk management tools available on every trading platform. Here are some of them:
Stop Loss: Apply a Stop Loss to close a trade if the market moves against your position.
Take Profit: Set up a Take Profit order to automatically close your position when the profit on your trade reaches the amount you set.
Negative Balance Protection: In the rare event that market conditions cause negative equity, negative balance protection will absorb the losses and reset your equity to zero.